Rising defaults in subprime mortgages may have started the global financial crisis rolling in 2007, but it was a failure in money market mutual funds that helped bring global capital markets to a halt nearly a year later. Plagued with a faulty pricing model and declining credit standards, and funded by sophisticated and financially agile investors, bad investments by some of these short-term funds added greatly to the sense of panic.
Nevertheless, some in the money fund sector continue to fight for a rollback on the limited systemic protections the Securities and Exchange Commission (SEC) imposed in 2013. A bill in the House of Representatives would undo a part of that rule prohibiting use of a stable net asset value for institutional money funds. It would further exempt such funds from another provision imposing default liquidity fee requirements when funds don’t invest 10 percent or more of total assets in short-term liquid assets.
It was the Reserve Primary Fund, one may recall, that created the money market panic in September 2008. The fund had invested $785 million in Lehman Brothers commercial paper, or about 1 percent of its $64 billion portfolio, for higher yields and an expected federal bailout like the one given to Bear Stearns earlier that year. When the bailout didn’t materialize, the value of the fund’s entire Lehman Brothers investment fell to $0, causing its net asset value to dip, initially to $0.99, then $0.97 after redemptions that poured in until the fund’s 3 p.m. close. The fund had officially “broken the buck.”
The Reserve Primary Fund got the headlines, but only because its sponsor could not provide enough support to mask the net asset value decline. According to a Federal Reserve Bank of New York study, at least 28 other money market funds also would have broken the buck in September and October of 2008 if not for the support of their sponsors and rules allowing them to round their net asset values to the nearest penny, giving the pretense of a stable net asset value.
Based on confidentially reported market-based values money funds reported to the Treasury at that time, the average loss among the 29 funds was 2.2 percent, though one reported expected losses of nearly 10 percent. Even more troubling was that many would have broken the buck before Lehman Brothers filed for bankruptcy. The near miss of a larger failure only reinforces the need for the SEC’s move to ban stable net asset values for the most systemically vulnerable money market funds used by institutional investors.
I have long supported fair-value accounting relative to cost-based reporting because fair value provides a better reflection of economic value. I believe the distinctions between the valuation models are important when it comes to warehouses and machine tools. When it comes to $2.7 trillion in money fund assets, though, the distinctions have potentially systemic implications. The Reserve Primary Fund nearly brought down the global financial system, even though its shareowners eventually received about 99 cents per share. A more accurate valuation system would give investors better warning and potentially prevent similar problems.
I supported the SEC’s proposal for floating net asset values for “prime” institutional funds as a way to limit redemption runs by the most-agile investors. I accepted stable net asset values for retail and government securities-based funds principally because neither were shown to have posed a systemic threat in 2008. Retail investors did not engage in mass redemptions, and government-guaranteed funds benefit from investor flight to quality.
Investors have responded to these changes as expected. The Investment Company Institute reports that prime institutional assets fell by nearly 75 percent to $376 billion in 2016, from nearly $1.3 trillion a year earlier. Taxable government funds absorbed most of the shift, swelling to more than $2.2 trillion in 2016. So long as the SEC holds the line on investment restrictions, these funds should not create systemic problems. Ultimately, increases in yields in prime funds could overcome investor reticence.
Regardless of how the House bill is structured, rolling back the abolition of stable net asset values for prime money market funds would be foolish and dangerous. If anything, we should eventually require floating net asset values for all money market funds. That would be the systemically sane approach.
Bjorn Forfang is deputy chief executive officer of CFA Institute.